Cost of Raising Money

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At this point, we're attempting to figure out how much money you need to open your business, with the objective of determining whether you'll need to obtain a loan for some portion of it. But don't forget that the interest on any loans you take out becomes part of the money that you need!

There are several different sources for obtaining the dollars you'll need to start your new business. Let's take a look at those choices and evaluate their relative costs. If you're interested in a detailed explanation of each of the choices and how you go about choosing among them, see getting financing for your business.

When we say "obtaining the dollars," we're really talking about two separate processes because banks (if you're fortunate enough to get a bank to lend you money) will not lend you 100 percent of the funds you need to start your new business. Banks and other lenders will want you to have some of your own money on the line as well.

By most estimates, a lender will expect you to put up at least 25-30 percent of the startup costs yourself. Thus, if you estimate that your startup costs are $50,000, you will need to be able to put at least $15,000 of your own money into the business. But what if you don't have the $15,000? Let's take a look at some of the ways you might raise the money:

• Personal savings: if you have the money in savings and don't need to raise it elsewhere, that's great. But be careful about using your retirement savings to fund a new business. There is always a risk in starting a new business, so make sure to evaluate your alternatives carefully. In fact, unless you have funds over and above what you intend to use as a retirement fund, you should probably raise the money elsewhere.
• Friends and family: if you don't have the money on hand, friends and family are normally the least expensive way to raise funds because they may not charge you interest, they won't require you to submit a business plan, and they're usually the only ones who will fall for your pleas for sympathy. (Try the "I don't have any collateral or business experience but I really need the money" approach on your banker and see if it works. If it does, please send us the name and address of our new banker.)

Work Smart If you borrow money from your family or friends, put it in writing and treat it like it any other loan. If they don't ask you to pay interest, then set up the loan to pay them whatever the prime rate is. Although this will protect them, you're doing it to protect yourself as well. Suppose your uncle decides to take an expensive vacation and wants his money back? The document should spell out under which conditions the money has to be returned. Suppose you want to sell your business? If you don't have any record of the loan, a prospective buyer may be scared off by an erroneous belief that there isn't any money in the business.

• Equity money: equity money can come in the form of private investments from friends, family, and interested strangers. The interested strangers may be other successful companies that wish to have an interest in your company vs. franchising. And they may bring the same kind of expertise and industry experience to the table.
• Home equity loans: if you own your own home, it may be your biggest source of capital to start your new business. Call around for the lowest rates. Also, find out whether there are any other hidden costs that you'll have to pay at closing. If you use your home for financing, get a business loan that uses your house as collateral instead of a home equity loan. This may enable you to write off the interest expense as a business expense instead of as a personal itemized deduction on your income tax.
• Credit card loans: raising money by using your credit cards should be your last resort because the interest rates are so high. If you find yourself in a position where this is your only choice, you should probably reevaluate your new business idea. Take a hard look at the reasons why no one is willing to lend you money. But, if you really believe in yourself and in your idea, go for it. You won't be the first person to finance a successful business by using credit card debt.

Warning A cautionary note on using credit card loans. The annual interest rate is over 18 percent per year on most revolving credit cards. There are many other less expensive ways to borrow money, with lower interest rates, higher credit limits and longer prepayment terms. Examples include a second home mortgage or collateralized loans from banks or private credit companies (e.g., Household Finance).

• Partnerships — another means of raising startup money is to bring in a partner who has the funds. But use caution when taking on a partner. Remember, you will have to give up something in return for the money, usually some of the control, profit, and freedom of running your own business. For more information on the ins and outs of setting up a partnership, see partnerships.

Once you're able to raise the 25-30 percent you'll need, the next step is to raise the other 70 percent. Although any of the sources just listed can be used to raise this money, you'll most likely turn to one of these sources:

• Bank loans: banks are becoming more willing to make small business loans, provided that you have some collateral (real estate, equipment, marketable securities etc.) and can convince the banker that your business has strong, reliable cash flow from which to make loan payments. The cost of taking out a small business loan will vary from lending institution to lending institution. Call around for the best rates. And ask your friends and acquaintances for their recommendations. One thing that won't change much is the documentation that you'll be expected to provide to them when you apply for a loan. For a complete discussion of the documentation you'll need, see debt financing.
• Government loans/guarantees: for a government loan, you still have to go through a bank, so the paperwork demands are there. Government loans generally require collateral and may change higher fees, but they may permit you to borrow for a longer term. Ask your banker whether you qualify for an SBA loan. For more information about the types of SBA loans that may be available, see our discussion of federal resources.
• Local loans: depending upon where you live, you might be able to get a low-interest loan from your state or community. Some communities have what are called venture loans, which are small loans (usually up to $5,000) that you can get without having any equity. The catch is that they're tied to job creation, so you have to be able to show that you'll be creating new jobs. For more information on these local loans, see state and local government loans.
• Franchisor loans: if your new business is going to be a franchise operation, then look to the franchisor as a financing source. A reputable franchisor will generally assist you, the franchisee, in obtaining financing for a franchise. In many instances, the franchisor will be the source of the financing or they will be able to refer you to lenders that they have worked with before. Lenders are more inclined to provide financing to franchises because they are less risky than businesses started from scratch.